Yes. Anyone outside of the Australian investment scene can be excused for their lack of interest the price of iron ore. With that in mind, please read on. In Australia, the iron ore price is a measure of national health. The nation’s richest person Gina Rinehart derives the majority of her wealth from iron ore assets. Rinehart is also the richest women in the world. Australia’s Pilbara region is home to one of the most attractive geographies known to iron ore miners – not only are there huge deposits of high grade ore but suitable infrastructure and proximity to Asia ensures the commodity can be easily commercialised. Iron ore is used in the manufacturing of steel and the world’s largest steel factory – China – continues to produce near record high levels.
So what’s the fuss about? Iron ore is just one single commodity but it has statistical significance to the Australian stock market. BHP Biliton for example is the largest single exposure on the Australian ASX200 index and by a large factor. It generates around half of its earnings from its iron ore businesses. Rio Tinto – another key index constituent – generates more than three quarters of its earnings from iron ore. Fortescue Metals – with a market capitalisation of around US$15.5bn at the time of writing – is a pure play iron ore producer who has returned an average total shareholder return, annualised at 92.5% over the past ten years to shareholders.
The iron ore price collapsed in September 2012 sending many key Australian shares in the same direction. During the period of hyper-negativity, we published a note titled “Is there Chinese growth story over?” In that note we wrote “China’s steel mills would have to drastically stop consuming for the iron ore price to remain below US$100 per tonne. “ We also said the fall in the iron ore price at that point in time was temporary and “A further selloff in iron ore stocks could provide a great medium term trading opportunity for those with patience – BHP, Rio Tinto, Atlas Iron and Fortescue Metals could all represent compelling value at current prices.”
Returns on Australian listed BHP, Rio Tinto, Atlas Iron and Fortescue Metals over the past three months are 12.3%, 19.9%, 11.5% and 20% respectively. The biggest question now on trader’s minds is when the iron ore price will begin falling again after rising from around US$85 per tonne to a close of US$158 last night. Consensus is at around US$100-120 per tonne for the year, bears think another crash is imminent and even the bulls are questioning the sustainability of prices above US$150.
We think US$200 per tonne is a chance that very few are factoring into the market and one which is possible, not necessarily probable, based on the following factors:
* China continues to manufacture steel at annualised levels in line with recent records. In December the annual daily rate of output was around 1.9m.
* India has imposed a ban on iron ore mining due to environmental concerns, leaving many India steel mills scrambling for supply to fill the void. We estimate India produces around 250m metric tonnes of iron ore annually. Australian production is in excess of 400m, so India’s void is meaningful.
* US$200 per tonne of iron ore compares with around US$275 per tonne of wheat and US$526 per tonne of soybeans on current the Chicago Board of Trade prices. Robusta Coffee will set you back around US$1961 per tonne based on current Euronext prices. A tonne of copper is trading above US$8000.
Bottom line – There aren’t too many brave analysts out there willing to forecast a US$200 iron ore price, nor company executives willing to put their neck on the line and risk being wrong after September’s falls. Chinese steel mills want the best price possible and have no interest in talking up the price. But in the remote chance that iron ore does continue to surprise, there will be massive earnings upgrades in the key Australian iron ore producers and upward momentum to the ASX200 index overall.